Financialism, Bubbles, & Law Schools

I must’ve heard of the term “financialism” somewhere (probably as “financialized”), so I looked it up. It’s not in the dictionary yet, but I suspect it will be. Two years ago Tom Armistead stepped up to define it:

Financialism is an economic system where the primary activity consists of creating and manipulating financial instruments. Financial instruments…are in their original form firmly linked to economic reality. However, when financialism sets in, financial instruments become progressively further removed from their role in supporting commerce in the real world and develop a life of their own.[i]

Armistead essentially grounds his definition of capitalism concretely: an economic system that creates things people need. Financial regulation protects capitalism from financialism. Perhaps he could’ve emphasized how financialism enables asset bubbles, for the term links nicely to my semi-off-topic readings on Japan’s economy. Readers may not know that I spent a good chunk of my adulthood in Japan, and while there people were still talking about the real estate bubble that wrecked its economy twenty years ago.

If an economy lacks the kinds of regulations that Armistead proposes, bubbles form and then burst, leaving the economy with a high overall-debt-to-GDP ratio. In Depression-era America, that was roughly 180%, 1990 Japan 450%, and 2007 U.S. 350%, courtesy of ThoughtOfferings.

The solution? It depends on your economic ideology. Conservatives (?) will tell you to bail out banks to prevent a depression—hence TARP. Austrianists[ii] will tell you the debt must be worked off, and any government intervention simply fails while increasing public debt, citing Japan’s experience between 1990 and now; alternatively, they point to the sovereign debt crisis Greece faces. A Keynesian will tell you that government interventions work, citing post-WWII America.

Personally, I side with the Keynesians on this one. Why?

(1) Something happened between 1929 and 1945 to put the U.S. on track, and it wasn’t lassez-faire government. Growth tracked New Deal deficit and wartime spending. You can see the massive growth in the U.S. financial sector during my lifetime here:

(2) Greece is a bad example because (a) it doesn’t have its own currency (compare it to Iceland, Poland, or 2000s Argentina) and (b) its government wasn’t even collecting taxes. Weimar Germany is a poor example because its hyperinflation related to gold-denominated war reparations payments, which incidentally, it finally paid off late last year. The U.S. Treasury can issue treasuries, have the Federal Reserve buy them, and then rebate the interest back to the Treasury. Much like a corporation retiring its own stock, there’d be no interest burden on future generations.

(3) Japan didn’t really adopt Keynesianism. I lean on Xie:

The Japanese government did choose to let the corporate sector earn its way back, first by preventing bankruptcies and second by stimulating demand. To achieve the first goal, the government kept interest rates near zero and Japanese banks did not pursue mark-to-market accounting in assessing borrower solvency. With a big chunk of the corporate sector zombie-like, the economy, of course, was always facing downward pressure. The government had to run large fiscal deficits to prop up the economy. After the bubble, Japan’s economic equilibrium stagnated and the fiscal deficit swelled.

Without wiping out the debt, all the “roads to nowhere” Japan built to connect rural towns were ineffective. The trick to cleaning up the leftovers from an asset bubble is to (a) encourage bankruptcy/restructuring/debtor-bailouts, and then nationalize any failed banks and resell the good assets to the public, (b) increase government spending in the interim,[iii] and (c) adopt regulations to prevent the problem from occurring again. The result increases the proportion of government debt to the total, but private sector debt is wiped out and the economy will grow out of the debt, reducing the absolute percentage. Sadly, the U.S. is doing neither of the first two (deficit increases have been due to drops in income tax revenue): mortgage cramdowns are still barred, and banks were bailed out for more than their market value instead of being nationalized after going bankrupt. I don’t know enough to comment on the financial regulation bill.

So how badly financialized is the student debt sector of the economy?

Nasser, who’s my new favorite old-school New Dealer, adeptly describes how higher education does not lead to “knowledge jobs” in the “New Economy.” Much of his article is spent explaining how states cut public universities’ budgets, but allow them only so much in tuition increases—a 14% cut for a 7% increase. The public system gets overloaded, so everyone spills over into private non-profit and then to for-profit education.

Critical to assessing any asset bubble is the default rate:

There is about $830 billion in total outstanding federal and private student-loan debt. Only 40% of that debt is actively being repaid. The rest is in default, or in a deferment, which means payments and interest are halted, or in forbearance.

60% of loans in limbo means misallocated capital and money that’s not going back to the banks to be used to finance things people need. As a chunk of banks’ assets are diverted this way, the non-performing loans eat up their balance sheets. When this near-trillion dollar bubble pops, the result could be TARP 2. Unfortunately, the actual solution requires bankruptcy, government spending, and rethinking how higher education is funded. These require more thought-work than taxpayer bailouts.

But to bring things from the universal to the particular of this blog, how does financialism affect America’s law schools? Let’s compare Xie’s description of China’s current real estate bubble—the largest in world history—to your average law school:

China’s businesses increasingly focus on asset investment rather than core business. When an asset bubble boosts corporate profits, it seems benign at first. Nobody sees the harm. However, when businesses earn profits from the investments in each other rather than their corporate businesses, their operating profitability deteriorates because they don’t invest in their core businesses anymore. Accounting profitability is just a bubble.

What is a law school’s core business? Producing practice-ready attorneys as cheaply as possible. Yet how do law schools “earn profits” off debt money if they’re non-profits or public schools? What is the “accounting profitability”—the financialized side—of a law school?

Answer: Prestige.

I concede there is a bleeding-over of core business and rankings dog-piling, but every time a law school dean sends out a letter at the beginning of the school year, what does he or she discuss? New faculty hires, increased student diversity, interesting scholarship, new clinical programs, and new facilities. Reining in costs is not up for discussion, and once the bubble pops the money is gone for good. If you look at law schools’ websites, as I’ve been doing for the research project I’ve been promising, you’ll find that they’re savvily (speaking of words that aren’t in the dictionary…) designed to direct prospective students towards financial aid. That prospective law students can’t finance their own way through law school is taken as a given, not as a problem.

Nasser closed his piece with this delightful nugget:

We need to begin thinking of political organization that has little to do with the ballot box. And thinking won’t be enough…

I think it’s also time for legal educators to minimize the damage to the profession’s reputation the bubble will cause by demanding bankruptcy and higher education finance reform for students and graduates because make no mistake: there will be no Legal Education Relief Program (LERP) to bail law schools out.

[i] Sharper readers may realize that the term bucks Marx, who viewed the speculative booms and busts of 19th century gold-standard England as capitalism at its worst. Read Brad DeLong on the subject.

[iii] I’m only mildly in favor of directly devaluing the currency to produce inflation. It does work, reducing the burdens on debtors, but it’s a flat tax on all net creditors, many of whom knew of the bubble and stayed clear. Instead, per (c), I’d increase capital gains taxes. If you’re going to redistribute the wealth, at least hit the wealthiest first. Ultimately, though, we have to remember that poverty is its own curse. No one benefits.